Disinflation Encouraging

First, let me say that the rapid moderation in price increases is welcome news for consumers and investors alike. I don’t want to minimize the progress that’s been made. But the rapid price increases we’ve endured over the past 2-3 years are not reversed by the moderation in inflation rates (disinflation) we’ve enjoyed more recently. While some prices might decline in certain categories of goods and services (notably including energy), nobody expects the economy to fall into a situation of outright price decreases, or “deflation.” This is an important distinction because it means that consumers will continue to pay high prices for non-discretionary living expenses like food, housing, transportation, health care and child care even as the future increases in those prices slow.     The chart below shows the year-over-year changes in average hourly earnings and the consumer price index (CPI) beginning in January 2020 which was the month in which the first confirmed case of COVID was reported in the U.S. You will see that the initial impact of the virus’s arrival was that wages spiked and inflation dipped. A study released by The White House in April 2021 attributed the wage spike to the fact that, “millions of relatively low-paid workers lost their jobs, while relatively high-paid workers remained employed.” That change in the composition of the labor force drove the increase in wages. The drop in the CPI was obviously due to reduced demand associated with COVID lockdowns. In any case, the main point of the chart is to show that following those initial impacts, prices (depicted by the gray line) rose faster than wages (depicted by the blue line) for 25 consecutive months beginning in April 2021 and ending in May 2023. 

The next chart shows the cumulative impact of inflation and wage growth since the beginning of 2020. You will see during the initial couple of years following COVID’s arrival wage growth outpaced price increases. However, beginning in May 2022, the cumulative impact of price increases surpassed the cumulative impact of wage increases, leaving the consumer’s purchasing power lower than it was at the end of 2019. And looking out further to October 2023, the consumer is still no better off in terms of purchasing power relative to the end of 2019. And things are even worse for low- to moderate-income Americans because prices for non-discretionary goods and services have been growing at a faster rate than more discretionary purchases. These means that the greatest impact from high inflation has been on the least fortunate among us. Not a good outcome. 

The above analysis goes a long way in explaining the recent weakness in consumer confidence as well as the dissatisfaction with the current presidential administration. Most people are simply no better off financially than they were four years ago. Even though the inflation rate is down by nearly two-thirds, consumers are increasingly living paycheck to paycheck now that COVID-related savings have been depleted; the labor market appears to be softening, and prices keep going up. This is not a recipe for political peace and harmony. And I suspect it will get worse before it gets better.

The gathering pressures on the consumer, combined with the delayed impact of interest-rate increases, continue to justify a more defensive posture. I suspect that earnings estimates for 2024 and 2025, both of which translate to 12% growth, may ultimately be revised downward. And if earnings estimates do begin to head lower, it would be much harder to justify the current premium valuation for the S&P 500 (18.8x forward earnings compared to a long-term average of 16.4x). A focus on quality companies with rock-solid balance sheets, many of which haven’t fully participated in the recent market strength, could help weather any storm that may come.